GAAR paranoia: FII funds fear Vodafone-like tax

MUMBAI: The government's strident stand on Vodafone and its decision to tax indirect transfers have raised concerns among foreign institutional investors. While the deferment of General Anti-Avoidance Rules ( GAAR) has come as a relief to offshore portfolio managers, many FIIs fear foreign investors may be caught on the taxman's radar.

Their worries, emanating from plain reading of the law, could deepen if the government does not formally clarify its stand on the matter.

Foreign investors - institutions as well as individuals - investing through FIIs are like mutual fund investors subscribing to units, or similar securities, issued by the fund. As and when these investors redeem the units and book capital gains, underlying shares in the Indian market are sold.

"Under the circumstances, FIIs apprehend that such indirect transfer of assets in India could cause the government to levy tax. If that's the case then FIIs and custodians will have to deduct tax before remitting the money," an FII broker told ET.

"This may result in an unusual situation where the investors in an FII fund may be technically chargeable to Indian tax even when the foreign investor distributes income earned as exempt long-term capital gains in India to such overseas investors.

It is important to remove any scope of such an interpretation," said Gautam Mehra, executive director (tax & regulatory services), PricewaterhouseCoopers.

Speaking to ET, a finance ministry official said the Central Board of Direct Taxes may define "what substantial value derived from assets located in India" means to clear the air.

Wary of Amendment

A general guideline or a circular may be issued to clearly define what structure may or may not attract tax, said the official. The finance bill proposes a clarificatory amendment that would make all indirect transfers taxable if substantial value is derived from assets located in India.

"These investors would not attract tax but a guideline may be prescribed to specify what kind of transactions and structures will fall in the ambit to clear any confusion," the official said.

The government has already said investors of Participatory Notes (PNs) - which are offshore securities or derivatives to trade in Indian stocks - would not attract tax. The same principle may be extended here, said another official in the ministry.

Indeed, group level restructuring, like merger of offshore holding or investment companies of MNCs with 'substantial' assets in India, could attract tax if they are not specifically exempted.

According to an official with a custodian bank, while it may not be the government's intention to impose a levy on FII investors, the law could lend itself to misinterpretation by tax department officials in the absence of a proper clarification.

"For instance, there could be a threshold of 10 or 15% below which such indirect transfers would not be taxed. In other words, there would be no tax on investors subscribing to less than 10 or 15% of the FII fund," said the person.

The concern is shared by FIIs who invest through Mauritius and Singapore, and are not required to pay short-term capital gain tax currently as well as those who are based in other centres like Luxembourg.

For the latter, a levy on indirect transfers would boil down to multilayered taxation - a short-term capital gain tax paid by the FII followed by tax which may have to be paid by fund investors.

Several FIIs invest through destinations that have no tax treaties with India. Often their exposure to India is part of a global fund investing in other markets.

"Yes, there is a fear. Since the way Section 9 (of the I-T Act) is worded, any fund which has substantial Indian investments could be exposed to the risk when it redeems the shares of the investors or the investors transfer their shares, such transfer could get caught into the provisions of indirect transfer.

Though, that does not seem to have been the intent, and in some sense the FM and authorities have been saying that they are not intending to cover such fund vehicles in this net and that it is meant to cover only Vodafone-like situations, the fact still remains that the provisions could be interpreted otherwise," said Siddharth Shah, prinicipal and head (fund formation) at the law firm Nishith Desai Associates.

And, in fact, said Shah some funds may choose to withhold tax on redemption of the shares of the investors to avoid being exposed to any penalty or interest.

According to him, internal restructurings globally where there is an indirect Indian asset which contributes to 'substantial' value of the overseas entity (substantial is not defined), would trigger tax under these provisions.